Intel CFO Smith Defends Tablet Chip Economics; ‘There’ll Be Just Two Vendors Left’ at Some Point

By Tiernan Ray

Intel's chief financial officer for nearly 7 years, Stacy Smith.

In town for various functions, Intel (INTC) CFO Stacy Smith was kind enough to drop by the Barron's offices for a chat.

In case you were wondering, Smith is coming up on 7 years on the job, and he has no plans of going anywhere anytime soon. He points out that there is a tradition of long-lasting CFOs at the company, citing predecessor Andy Bryant, now chairman, who held the spot for thirteen years.

Smith deftly batted away questions about the economics of the chip business as Intel pursues its objective of being a more competitive vendor of chips for smartphones and tablets.

I cited a report put out yesterday by Bernstein Research's Stacy Rasgon , who speculates that the expected hit to gross margin this year implies Intel will be selling tablet chips at or below cost. Rasgon pointed out what seemed to be an embedded cost, or implicit cost, if you will, of $51 incurred by Intel for each tablet chip shipped, including subsidies, in terms of the impact to gross margin.

Smith brushed aside a copy of the report proffered to him, when asked to review Rasgon's numbers, instead rejecting the premise outright, shooting back, “Anyone who thinks we have a $50 cost for these chips is wrong.”

In particular, he points out that the special costs Intel is incurring that are pushing down gross margin for the company this year are not the cost of the chip itself.

Rather, rebates, in the form of “contra revenue,” and one-time engineering fees, called “NRE,” are meant to reduce the “total bill of materials,” which includes the higher cost of things such as DRAM and other circuitry that must go along with Intel's tablet chips.

The chips themselves will maintain “competitive prices” compared to offerings from other vendors, he insists, without Intel having to sacrifice gross margin, even for tablets whose retail price is $199 or lower. “Across all tablet segments” is Intel's rallying cry.

It's important to realize, Smith said, that Intel is able to cost-reduce to match the lower prices of such products, noting that the cost to Intel to produce an Atom chip is one-fourth the cost of its top-of-the-line “Core i7” parts. New versions of Atom chips next year, “Broxton” and “Sofia,” will bring down Atom's costs further.

“This is going to be even more so the case as we sell Quark, some in the single-dollar price range,” he said, referring to the new line of chips for smart wearable computers and such, introduced last fall.

“We don't fear lower price points; it is in the nature of technology for prices to come down and for things to become more and more useful, so that people adopt the technology.”

It is not the case that we don't have a competitive cost structure. We will get paid a competitive price for our chips, across different competitive segments. What you have to understand is, we were originally targeting the $500 tablet market with our chips, because we have been bringing really high performance into that market. But the bill of materials for Atom chips at this point has very little to do with the SOC [system-on-a-chip] itself. The memory that works with our SOC is high-end, more like what you'd find in a PC. And so we are doing the value engineering to bring down the cost of that to our partners. That takes a little time to do. But by the end of this year, the bill of materials delta, if you will, gets pretty small.

Smith noted that “we've been through the same drama with this [mobile chips] that we went through when segment-zero PCs came onto the market,” referring to the industry term at the time for the sub-$1,000 personal computers that showed up toward the end of the 1990s.

“People made the same kinds of arguments about us, and how we faced lower prices then. But people always underestimate Moore's Law and our ability to bring down the price of manufacturing.”

I brought up my contention, made in Barron's magazine, that the company's slide showing steady prices for its PC chips, and declining costs, needs to be updated to accommodate the pricing effects of Atom chips, which are separated from the Core chips in a different part of the income statement, called “Other IA.”

The slide shows the relationship of chip prices and Intel's manufacturing cost, but only for its PC chips, without showing the effect of including the cheaper Atom chips in the mix. I think that's potentially misleading.

Smith responded by noting that Intel will be able to maintain gross margin even as it sells chips at lower prices, holding to the company's long-term goal of corporate gross margin of 55% to 65%. After a bit of back and forth, he indulged my suggestion that he consider revising the slide to reflect the effect of Atom chips. I don't expect Smith to actually do so, but he is a gracious fellow and willing to humor reporters.

On the broader topic of why Intel is putting so much effort into the mobile market, when it is sure to initially bring in much less revenue than the PC business, Smith responded that “No one thing moves the needle for a $50 billion company,” referring to Intel's annual revenue rate. “But when you add up data center, and our software business, the NAND [flash memory chip] business, the Internet of things business, growing 15% to 20% per year, it adds up.”

“We want to have a nicely growing PC market, and maintain position there, and then have these new markets where, if it connects, it does it best with Intel.”

At the same time, Smith expects there will be a fairly dramatic shake-out in mobile chip suppliers.

“There will be just two suppliers at the end of the day” in mobile, he contends, although he wouldn't say which the other one will be. “You can decide,” he said, when I threw out names such as Qualcomm (QCOM), Broadcom (BRCM), and Nvidia (NVDA).

Speaking of companies not being able to go the distance, I asked Smith about the foundry business, a nascent thing, where Intel is committed to building more and more chips for customers, even some who are traditionally competitors. I suggested that if the rising complexity of making chips leaves other foundries such as Taiwan Semiconductor Manufacturing (TSM) in a tough spot, Intel could stand to grab massive volume of business from all those chip companies currently using TSM.

Smith's own enthusiasm was more tempered. He said the company looks forward to providing its services to many companies that “want to use the Intel architecture,” which is akin to ruling out Qualcomm and others who license ARM Holdings's (ARMH) competing instruction set. When I pressed the point, he sounded more broadly expectant, saying that “there will be a number of partners and customers who will say we want to use these leading-edge transistors in segments of our business.”

“We are the only ones left who build our own factories,” said Intel, though it is also the case for Samsung. “That gives us this manufacturing advantage that is hard to match. You know, [Intel founder] Gordon Moore said many years ago that the price of $1 billion for a fab put manufacturing beyond the reach of most companies. I think Gordon, it turns out, was right, but he was early by about 15 years. It turns out about $3 billion to $4 billion has proven to be the threshold where most parties just can't keep going” with their own factories.

Another topic was the dividend: it hasn't risen in almost two years.

Smith noted that investment in capital expenditures, primarily to build and outfit Intel's chip factories, or fabs, is a priority because, as Intel sees it, “Investment in capex is something investors can't get any other way.”

I noted that capex is supposed to be about flat this year compared to last, at roughly $11 billion. If Intel is not spending more, than why not up the dividend?

Smith replied that “Our goal for the dividend is 40% of free cash flow” annually, and that the company has been disciplined in sticking to that metric.

With revenue this year expected to be flat, and capital expenditures expected to be flat, it's reasonable to expect that free cash flow will be about the same this year, and, hence there will be no dividend increase, I pointed out to Smith.

However, Smith would not confirm that speculation, stating the company has not offered a forecast for free cash flow. He did, however, note that “We've brought down net cash balances by in excess of $10 billion” in recent years, so Intel is hardly hording cash.

“We were running in the low 20s [billions] of net cash balance, now we're into the low teens,” he observes.

I also asked about the new CEO at Microsoft (MSFT), Satya Nadella, named yesterday to replaced Steve Ballmer.

“I haven't met him, but I hear Satya is super smart, and intellectually curious. In that regard he shares some traits with Brian [Krzanich, Intel's CEO]. Brian also likes to dive deeply into the technology itself. That basic intellectual curiosity is really important.”

Added Smith, “Relationships at this level are critically important because they are what helps teams to work well together. Microsoft has historically been that partner for us. I watched as Paul [Otellini, Intel's previous CEO] and [late Apple (AAPL) founder] Steve Jobs became friends. It's the kind of thing that can transform entire markets.”

Before he left, I asked Smith if he is writing more Haiku for future earnings releases, as he did for the analyst day meeting.

He said he is, but he declined to recite the latest one for me, citing SEC regulations.

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There are 11 comments

FEBRUARY 5, 2014 9:57 P.M.

the_floating_gate wrote:

"In particular, he points out that the special costs Intel is incurring that are pushing down gross margin for the company this year are not the cost of the chip itself."
Thank you for correcting a misleading perception created by Bernstein.
Now you must "teach" James Covello Moore's second law - he's a bit slow to that regard

You also need to explain the term capital intensity (($ Revenue from advanced technology relative to $ capex for advanced technology) and how Intel performs in this matrix relative to TSMC et al

FEBRUARY 5, 2014 10:01 P.M.

Anonymous wrote:

good piece. thanks for detailing this so thoroughly!

FEBRUARY 5, 2014 10:06 P.M.

Anonymous wrote:

this matrix relative to TSMC et al

metric it is

FEBRUARY 5, 2014 10:10 P.M.

Hllbilly9989 wrote:

We heard essentially the same for the last twelve years, give or take, but the price has hovered around the same area during the entire period.

Could it be the result of the obvious inbreading where no new and fresh blood (with fresh thinking) has been encouraged. Put differently, is it the case of too cosy a relationship of the inside brass protecting each other? Where has the alleged Board of Directors heen in that oeriod? Just pocketing those very generous fees? Looks like it, doesn't it?

FEBRUARY 5, 2014 11:20 P.M.

bubba@aol.com wrote:

“There will be just two suppliers at the end of the day”. Presumably Stacy implied that Intel would be one of those suppliers. That kind of talk worries me. My company, a large computer OEM, used to tell a similar story to employees in the 1990's. They said Dell would disappear, IBM would probably survive, and HP might survive. The only company that was sure to survive was ours, Compaq.

FEBRUARY 6, 2014 12:37 A.M.

svalleyguy wrote:

What is missing from this and most other stories on Intel is- Who will be your customer for these phone/tablet chips? The only company that is making decent margins in the phone and tablet business is Apple. They use their own custom ARM chip. Samsung has higher volumes in the phone market, but isn't making much margin. And, they too have their own chips. The rest of the phone/tablet market is trying to compete with the cheap Asian Android clones, in a race to the bottom. With 10" tablet around $100-$150, how can Intel make any money as a vendor? What is the best they can do in a BOM for something like that?

Google mints money from search and ads, Apple is a fashion company with the highest gross margins, by far, of any hardware company. Who is left? Nobody. And that is Intel's customer.

FEBRUARY 6, 2014 8:24 A.M.

william dixon wrote:

Intel is consistently coming up short or barely on earnings. This is what a shareholder does not like, and I simply wonder when or if it will ever get better.

FEBRUARY 6, 2014 9:30 A.M.

Jmes Bond wrote:

To rely on vendor consolidation is not a strategy. As some others have pointed out, this is either a very consolidated space from a customer POV (Apple/Samsung) or very fragmented (lots of smaller guys requiring low ASPs). So step 1 is defining the customer and I am afraid it looks murky - at least from the sidelines. They may however be seeing a customer base and economics which may not be very visible from the outside.

FEBRUARY 6, 2014 9:42 A.M.

AnonymouOne wrote:

Intel worries me these days. Intel missed mobile in many ways. Apple came to Intel knocking on the door for Intel chips for their what is now known as iPhone, previous CEO turned them down. Apple created their own chip design team. There are too many non techies at the top, and in the board at Intel, making wrong decisions. Without Engineering/Science background it is very difficult to make right forward looking technology decisions. I am not sure why a finance/accounting background person is in a chairman's position, and a Business background without engineering background person selected as president.
Qualcomm is led by PhDs in engineering/science, they have been making right technological decisions, positioning the company always into the future. Qualcomm is soaring, Intel is stagnant, and on a declining path. Intel board needs an overhaul.

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.